After the Fed monetizes almost every dollar of net U.S. debt issuance in 2020, the supply of U.S. debt in 2021 will far exceed the Fed’s purchases, and that’s before even considering the possibility of another round of massive fiscal stimulus.
We can’t help but wonder if another “crisis” will emerge in the next few months that will justify another expansion of quantitative easing by the Fed.
This is possible, since central banks plan to double the size of their balance sheets in just two years, and there is already an oversupply of money.
Assuming that the Fed’s monthly bond purchases remain unchanged, what would be the impact on U.S. Treasuries and other types of bonds? Accordingly, what is the impact on the equilibrium price of the bond?
To answer this question, Nick Panigirtzoglou, a quantitative analyst at JPMorgan Chase, examined the supply and demand for bonds in 2021. JPM expects bond demand to fall even more sharply next year, despite a significant drop in global bond supply, due to reduced bond purchases by central banks in the world’s four most developed countries.
Looking first at the supply of bonds, JPMorgan expects the supply of bonds to decline by at least $1 trillion in 2021.
Our credit strategy analysts believe that net issuance of U.S. HG corporate bonds will halve, from about $1 trillion in 2020 to $450 billion in 2021, primarily due to a reduction in the supply of spread products.
In contrast, the supply of government bonds declined only slightly, as the decrease in government bond issuance outside the U.S. was largely offset by an increase in U.S. Treasury issuance. This is because this year’s deficit financing will come mainly from Treasury bills issued in the first half of 2020, while the Treasury has been gradually increasing its bond issuance since May.
JPMorgan expects that by 2021, there will be $670 billion fewer Treasury bills outstanding, while the deficit will be financed by a $2.8 trillion supply of U.S. debt, compared to a $2.29 trillion supply of Treasury bills and a $175 million supply of U.S. debt in 2020.
Also on the demand side, JPMorgan says the biggest change will be the strength of the central bank’s quantitative easing policy.
The investment bank expects the four major central banks – the Federal Reserve, European Central Bank, Bank of Japan, and Bank of England – to buy $5.1 trillion in bonds in 2020. The main reason is that the Fed expanded its quantitative easing policy to provide liquidity at the end of March, while the ECB also expanded its bond purchases in early April.
However, JPMorgan Chase expects that the initial implementation of quantitative easing is too aggressive, the Fed will continue the current pace of bond purchases, and the Fed’s bond purchases will be reduced to about $3.6 trillion in 2021. While JPMorgan expects the Fed to propose further stimulus measures at its December meeting, it expects the stimulus to come in the form of an extension of the average maturity of Treasury purchases, rather than an acceleration of the pace of bond purchases.
As for the ECB, JPMorgan expects its overall bond purchases to increase slightly next year compared to 2020. It predicts that the ECB will expand the size of the PEPP by €500 billion on Dec. 20 and by another €250 billion in the second quarter of next year.
In addition, the Bank of England has announced that it will increase spending by 150 billion pounds in 2021, while the Bank of Japan’s net bond purchases in 2021 should be around 30 trillion yen, Panigirtzoglou said.
“Overall, this means that the four central banks will buy $1.5 trillion less in total bonds in 2021 than they did this year.”
In addition, bond demand is coming from the following sources.
- Commercial banks in four developed countries – the United States, Europe, Japan and the United Kingdom. They are the second largest source of bond demand in 2020, with their bond purchases at about $1.5 trillion, second only to central banks. JPMorgan expects demand from commercial banks to plummet by one-third in 2021, or by about $500 billion to $1 trillion.
- Foreign exchange reserve requirements. According to the International Monetary Organization’s COFER data, as many central banks responded to the impact of the epidemic on exchange rates by propping up local currency exchange rates, foreign exchange reserves fell by about $310 billion in the first quarter of this year, and the rate of decline slowed in the second quarter, falling by only two-thirds of the first quarter, or about $200 billion.
According to JPMorgan Chase data, the total demand for bonds from foreign exchange reserve managers is expected to reach $20 billion this year, as reserves are gradually accumulating from the second quarter of the year. If the dollar continues to depreciate in 2021, foreign exchange reserves will gradually accumulate and banks’ demand for bonds will be $80 billion higher than in 2020.
Pension funds and insurance companies in four developed countries – the U.S., Europe, Japan and the U.K. – purchased about $270 billion in bonds in the first half of this year, which is in line with their annual purchases of about $540 billion, and in line with the pace of the previous year. In theory, the strong stock market rally in the second half of the year could have led to a faster pace of bond purchases. However, demand for U.S. pension fund bonds is little changed from the beginning of the year because the stock market recovery has covered the U.S. fiscal deficit. Looking ahead, JPMorgan expects demand for pension fund bonds in 2021 to increase by about $100 billion from this year.
- Retail investors’ current annualized bond purchase demand is about $340 billion, and retail investor inflows into bond funds over the past 10 years have been about $500 billion. As a result, JPMorgan expects retail investor demand for bonds to increase by about $160 billion in 2021.
In summary, JPMorgan expects global bond demand to fall by nearly $1.7 trillion and global bond supply to fall by $1 trillion in 2021, so the supply-demand balance will be about $600 billion apart in 2021.
In response to this imbalance in bond supply and demand, JPMorgan says that at higher yields, depressed demand can quickly translate into higher demand if bond prices are low enough.
“Based on the relationship between the annual change in supply relationships over the past 10 years and the yield on the Global Aggregate Bond Index, this implies that bond yields will face upward pressure of just over 20 basis points next year, which would reverse a third of this year’s decline.”
Obviously, this sidesteps the question of how much of said supply and demand has already been priced in. Or rather, how much excess QE has been priced in in a market subject to Fed intervention.
JPMorgan optimistically believes that the $600 billion demand gap can be offset by a simple 20 basis point increase in yields, which the Fed will surely take advantage of. Because the Fed must be eager to steepen the yield curve, thereby easing the pressure on struggling domestic banks.
Others are skeptical because bond yields will spike once the Fed releases new forward guidance indicating that it will not only not expand quantitative easing, but will scale back its current $80 billion per month bond purchases.
Why do you say that? Because that’s exactly what happened in May 2013 when former Federal Reserve Chairman Ben Bernanke caused a “tapering panic”. At the time, yields spiked by 150 basis points, spooking the markets. And it was only the third round of quantitative easing that was being tapered. Considering that the scale and scope of quantitative easing is much larger now than it was in 2013, we can imagine the impact if the “tapering panic” occurs in 2021.
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